In 1996, Charlie Munger (Trades, Portfolio) gave an informal speech to a group. This speech is named “Practical Thought About Practical Thought?” in the book "Poor Charlie’s Almanac." Munger warned that most people don’t understand the speech. He said that it was an extreme communication failure when made, and people have since found it difficult to understand even when read slowly, twice.

This speech is by far the best case study that I have ever read or heard. While Charlie Munger (Trades, Portfolio) arguably popularized the idea of solving problems using a diverse set of mental models, unfortunately he has not given many examples of how he applies this multi-disciplinary approach in investment. It is the rarity of real life examples that makes this speech especially valuable. As I read the speech over and over again, I thought it may be helpful to step back, contemplate and extract some information on how Munger (Trades, Portfolio) uses mental models to solve practical problems.

You were in the year 1884 and to be chosen as the other partner in Coca-Cola's business, you must demonstrate, in 15 minutes, that your business plan will make Coca-Cola worth $2 trillion 150 years later, in the money of that time, despite paying out a large part of its earnings each year as a dividend.

This is a daunting challenge, and here is how Charlie Munger solved this problem:

Munger’s first step is to simplify the problem as much as possible. Munger is a big believer of Einstein’s simplicity philosophy (“everything should be as simple as it can be, but not simpler”). Another helpful idea is from Richard Reynman: "But the game is to try to figure a thing out, with what we know is possible." This simplification step should be your automatic first step in your problem solving process. In Coca-Cola’s case, Munger simplified the problem by identifying the two most important decisions - "making Coca-Cola into a strong, legally protected trademark and developing a product having universal appeal because it harnesses powerful elemental forces." Note here we have a multi-disciplinary action that combines the big thinking model and the business model.

Next, Munger proposed that we use numerical fluency to ascertain what our target implies.

"We can guess reasonably that by 2034 there will be about eight billion beverage consumers around the world. On average, each of these consumers will be much more prosperous in real terms than the average consumer of 1884. Each consumer is composed mostly of water and must ingest about 64 ounces of water per day. This is eight eight-ounce servings. Thus, if our new beverage, and other imitative beverages in our new market, can flavor and otherwise improve only 25 percent of ingested water worldwide, and we can occupy half of the new world market, we can sell 2.92 trillion eight-ounce servings in 2034. And if we can then net four cents per serving, we will earn $117 billion. This will be enough, if our business is still growing at a good rate, to make it easily worth two trillion dollars."

In essence, this step is doing the big picture math. Here we need to make some assumptions that involve profit per serving, servings per capita and total population by 2034 with reasonable confidence.

Naturally this will lead us to evaluate the assumptions we made earlier and see if they are reasonable. To test our assumptions with regards to the profit per serving, Munger again simplified it to the most important factors that will make our assumptions reasonable. These factors again involve interactions among multiple disciplines -

1. The creation of a beverage with a strong universal appeal - this is the application of herding and social proof from psychology.

2. The depreciation of dollar over time - this is application of money supply and demand, and monetary policy in macroeconomics.

3. "The consumers’ proclivity to inexpensively improve their experience while ingesting water will go up considerably faster" - this is the application of utility maximization concept in behavioral finance.

4. As technology improves, the cost of production will go down - in my opinion, this falls under the business model framework and specifically, the evaluation of technological improvement on a business.

Among the above factors, creating a universal appeal is the most important one and it is something we can exert some influences on. Therefore, Munger once again, simplified the problem by defining the two intertwined challenges of large scale, which if solved, would invent universal appeal. The key to attack these two challenges is to cause every favorable factor we can think of to work for us. Out of sheer brilliance, Munger proposed that we use a combination of elementary psychology concepts:

If we can apply those psychology concepts successfully, Munger points out that "we are going to start something like an autocatalytic reaction in chemistry, precisely the sort of multi-factor-triggered lollapalooza effect we need."

Now we have solved the problem of creating a universal appeal, the next step is to figure out the logistics and distribution strategy. Munger, not surprising, proposed another multi-disciplinary solution that involves the following concepts:

Spending heavily on advertising and sales promotion to create huge Pavlovian and social proof effects across all distribution channels (psychology).

"Avoid needless shipping cost and have many bottling plants scattered over the world" (product production and distribution - business model).

All the above efforts will help Coca Cola maintain a powerful profit-maximization distribution channel that will be crucial to the success of the business.

Munger then moved on to how to defend and solidify the business moat (business model). He proposed that we need to work obsessively to keep our formula secret (scarcity concept from psychology) and to ride the wave of technological advance that will help Coca-Cola with better transportation and expand product offering.

The final step in Munger's thinking involves inversion (big thinking model). Invert, always invert. In this case, Munger listed the things we want to avoid in executing the business plan. Even at this stage, he applies the multi-disciplinary approach. Let's take a closer look:

Coca-Cola must "avoid the protective, cloying, stop-consumption effects of aftertaste that are standard part of physiology, developed through Darwinian evolution to enhance the replication of man's genes by forcing a generally helpful moderation on the gene carrier."

Coca-Cola must "avoid losing even half of the powerful trademark." This is the application of business model framework.

Coca-Cola must avoid "bad effects from envy and focus on product quality, quality of product presentation, and reasonableness of prices." This is a combination of psychology and business model framework.

Coca-Cola must avoid "huge and sudden change in the flavor, which will trigger the hostile consumer super-reaction to deprival" (psychological biases).

And this completes the exercise.

The Coca-Cola (KO) case study is by no means simple, although Munger said it should be a simple exercise because all he used are elementary concepts from a few fields such as psychology and economics.

I think we can cultivate the habit of using multiple mental models in our decision making and problem solving processes. It will involve a 4-step approach:

Step 1: Identify and simplify the problem.

Step 2: Apply the big thinking framework.

Step 3: Apply elementary concepts from multiple disciplines where you see fit and pay special attention to concepts related to human psychology.

Step 4: Invert, always invert.

In order to adopt this approach, we have to make this a routine exercise and progress gradually, not in a fast spurt. To some of us, this means fundamentally change the way we approach problems, which is inherently hard due to the consistency and status quo biases. We also have to relentlessly widen our knowledge base so that we have the tools we need. I encourage the readers to spend some extra time on the big ideas from psychology. As you can probably tell, human psychology is the dominant discipline in his Coca-Cola case study.

And with that, I have nothing to add. Any feedback and comments will be greatly appreciated.

Comments

>> While Charlie Munger (Trades, Portfolio) arguably popularized the idea of solving problems using a diverse set of mental models, unfortunately he has not given many examples of how he applies this multi-disciplinary approach in investment.

Thanks for the article.

I find it ironic that there's a direct link to his portfolio right in the middle of the sentence where you argue that he has not given many examples. Frankly, I think it is possible to analyse POSCO or Wells fargo along the same lines as Mungers' analysis of Coca Cola.

I think you've made a fair point by saying that it is possible to analyze POSCO or Wells Fargo along the same lines. I probably should clarify that he didn't explicilty explain any other holdings in such details as he has, for Coca Cola. Of course one can do his own work if one can extrapolate based on his Coke analysis but that itself will be an enormously difficult challenge to start. I doubt many people can do that.

I agree. It is both simple and tough. Like "start with the As" or "Don't use leverage".

Of course, we can invert. What does he not use to get an estimate of value. p/b, p/e, roe, fcf.... don't come into it. It seems to me that within his framework, 99.99% of analysts are processing a mountain of not so relevant numbers.

You are dead on with regards to analysts not using relevant numbers. But on the other hand, if they do use the right numbers and think like Munger, you and I are gonna have a much harder time finding bargains:)

I very much like your Steps 1-4. I wonder if a Step 5 would be 'Try to kill the idea'. This would involve brainstorming all imaginable ways in which the idea could go wrong, and evaluating their likelihood. It would be related to 'Step 4: Invert' but has different dimensions also. Bruce Berkowitz (Trades, Portfolio) talks about how he does this for his ideas - sometimes even bringing in experts to challenge his concepts.

Thought I would share this quote from Charlie as it seems fitting, (and was used in the Oaktree Memo released today)

"I’m convinced that everything that's important in investing is counterintuitive, and everything that is obvious is wrong."

The concept of mental models is a must know but more importantly understanding them. As Einstein said, you must first learn the rules of the game, and then play better than everyone else, or something to that effect. Charlie has detailed a vast majority of them through various speeches. I wrote up a list of what I could find him explicitly telling students to focus on, a little while back. I believe Farnam Street also has a similar list (with more models).

vgm- I appreciate the comments and I think killing the company as a stet is not a bad idea. Like you said, it's related to inversion but have different dimensions. You can even make it the first step, like Buffett, who automatically think about the super-cat risk of a business.

Thanks for the quote. If I dare to add two things, I'd add (1) it's counterintuitive to the herd and (2) just because it's obvious doesn't mean it's wrong, it just implies an average result. I worship Munger's thinking model and I think the Coca Cola case study makes perfect sense. Imagine presenting this to a typical Wall Street analyst, they are going call you crazy, at least.

Both you and Farnan Street have done a great job with the list. The problem is, most investors with a college degree already know those models you and Farnan Street listed. I think the hard part is actually apply the mental models. As you can tell from this case study, it's enormously difficult to apply. Who the hell is gonna think Darwinian evolution and autocatalytic reaction are related to Coca Cola? Not to mention combine them.

I agree with you 100% "it's counterintuitive to the herd and just because it's obvious doesn't mean it's wrong" and I appreciate the Feynman like clarification between wrong and average. The point you also address about Wall Street analyst's is something we will likely never understand. Thanks for the kind comment (Farnam Street has definitely the better of the two lists) and I can see the problem with knowing, more importantly understanding and most importantly executing the mental models you currently possess. I have felt the pain of the saying "ideas are easy, execution is hard" more than once in my life. I guess it comes down to training yourself with processes and safe guards that become procedural through repetition.

Again great article and I agree with the complexity and difficulty surrounding mental models, it is always great to converse on the matter and have a refresher.

Munger is an under appreciated master of his time. One day the masses will understand . . .

On inverting, I believe Buffett has said that he spends large amounts of time thinking about all the things that can go wrong. His thoughts on nuclear bombs, derivatives as WMD, casino societies, impacts of inflation, tax rates etc. prove this, though I think he manages to keep it all in perspective while being able to identify potential hazards far in advance of many investors.

Charlie Munger (Trades, Portfolio) is a smart man, no doubt, but I dare to disagree. His appraoch doesn't explain the success of Coca Cola at all ! While all the logic seems correct, the success of Coca is still more unexplainable phenomen than calculated work of genius. Why ? Because the success of Coca Cola is the result of excellent execution more than anything else. Lets analyze the analisys of Munger.

1. Strong universal appeal. Really ? What a revelation. Every business owner dreams of universal appeal of his product or service. Only few will succeed.

2. Taste. Same as the first point. Its so obvious that great taste is required, but how you go and create this one in a million unique taste that will win against all the others.

3. Strong brand. Another no brainer. To build a brand you need money, in order to make money you need success converting into huge revenue, which in turn is based on the brand among other factors.

4. Technology. One more time, too simple. It was obvious to many that technolgy will make almost everything cheaper. It was obvious even two hundred years ago since people started using any kind of technology in manufacturing.

Coca Cola is a phenomen, that just can't be explained period. Of course one you become such an elephant its easier to optimize, innovate and get even bigger. But how do you so big at the first place while everybody else understanding all the same things somehow left behind.

Same with Google, read the book "The Google Story" . Larry Page was seriously thinking he could download the entire internet into his laptop. When they were working on it they didn't know what exactly they were doing. They were totally consumed by the creative process during which the magic just happens. The magic can't be explained. You can't explain why and how the thought that will create the breakthrough based on which your company will go into space leaving everybody else behind. For Google it was "the ranking algorithm" which was sorting the search results based on the number of incoming links. My friend was one of the first in the world to understand how it worked and made his first million dollars without even openning a business account. He was one of the most successful guys in the world working for dozens of affiliate programs. He created the script that was palcing any website to the top in the matter of minutes. Later Google started to realize the flaws in the algorithm one after another and started correcting them one after another. But at that point they already ruled the world. Sergey Brin originally from Russia (having mentality which is easy for me to understand cause I have exactly the same background) was insisting on not "no ads at all" policy. Sergey didn't want to do what brought Google billions later. He simply refused until Eric Shmidt finally convinced him. Can you really assume that all of it was planned from the start ? No way !

Yes all the greatest enterprenuers had an intellect, all of them were unique but none of them knew exactly what they were doing from the start. And most of them started with simple assumptions, sometimes written as we like to say in Russia on a napkin in a restuarant.

Soros is another example. His famous book which many have hard time understanding called "The Alchemy Of Finance". Success is more art that sience, success is more alchemy than anything else. Millions of books printed with titles "The Millionaire Mind" and so on, millions read them and somehow not becoming millioners in spite of having understood every word written.

Buffets biography written by Lowenstein has changed my life. It set me on incredible path. From bored IT consultant in Canadian banks I moved accross the ocean and did what many would think impossible, which is becoming investment banker without any formal education in finance in the age of 38 :) I managed to sell the idea of taking one Russian company to the owners after just reading few books on the IPO and moved accross the ocean to execute it. There are 7 IPO deals for small to mid cap compaines in Russia in a good year half of which is doing the company I joined. What are the chances ? One in a million ! There are only 500 public companies in Russia. How did I meet them ? I just typed few words in Google looking for an investment bank which would help me take the client public :)))) I picked random search result and they appered in our office next day. I was going to to talk to everybody to shop for better rates to see how would appear the most professional etc. But again I made irrational decision and picked them without seeing anybody else :) More than that the owners also picked them right away. Believe it or not they are far from being best investment bankers in the world. The Managing Director has close to zero knowledge in finance, he doesn't know what DCF is and doesn't want to study ! Not knowing what exactly he is selling only helps him sell. Why we picked them ? Because the universe itself by its magical hand was shaping my fate at this moment. Life is a mystery that can't be explained or understood fit into models etc. And so is the phenomen of Coca Cola. Graham book was read by millions but we have just one Buffet :)

I just want to add that being able to pick a good company as an investor is much easier task than being able to predict which business will succeed at phase zero. When you are looking at financials of say Apple you are already looking at success. Your job now is to just see if its fairly price if it will continue to grow as fast, fair price, idenitfying if the business has a moat and so on. The mountain is already standing in front of you and now you could go and try to invent theories on how it became the mountain and why. Btw according to Grahm "stay away from hot company in hot market" Apple is doomed to fail. It should ... :) One day. Or may be its already Coca Cola and it will keep growing forever. After all people like the taste, Apple stores are all over the world. It has enormous profits and cheap manufacturing. Go figure. The only thing people just want consume iphone 5 forever like they probably will consume Coca Cola :) May be one day Coca Cola will cease to exist ? Lots of questions to ask

I agree with the commenter above, the secret to Coca-Cola's success is luck. Nobody could have predicted where Coca-Cola would end up when the company was started in 1886. The Coke drink itself was orignialy used as medicine. Only decades later was the drink modified and became popular worldwide. Even the "secret formula" was developed through luck. I love Charlie Munger (Trades, Portfolio) and think he is a brilliant man, but here he is making it seem as if CoCa-Cola's success was predictable the whole time. The truth of the matter is that it was never predictable. People underestimate the importance of luck!

1) I don't think it was Mungers intention to prove anyone could have predicted Coca-cola's success from the start.

2) Good points though. In many (maybe most) cases, I think competitive advantages are not the result of a deliberate act but a consequence of some arbitrary circumstance.

For example, GEICO has a direct model because its customers were government employees. GEICO was just part of the system. GEICO didn't come to be because someone thought "hey let's see if the direct model will give us some advantage in the auto insurance space."

Having said that, detecting such advantages in hindsight can be rewarding. If only because it helps to evaluate management. Buffett sold Fannie and Freddie because he could see how management was making the wrong moves. Buffett understood what he owned well enough so he had time to bail out.

Charlie says invert.

The really valuable moats that I know of (KO, GEICO, SIAL, GOOG ....) are the result of some fluke plus a bright manager who recognised it and grew both the business and its moat.

So if the future is to resemble the past, what's the chance that Musk, Zuckerberg or for that matter Jobs come along and invent a competitive advantage that we will still be talking about in 2050?

Wanna bet that KO will be around and making more money in real terms by 2050?

How about Facebook?

The fact that the market says they are both worth about $160B is interesting to me.

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